Southwest's gamble on fuel prices pays off

Southwest Airline s, in danger for much of this year of losing its quirky dominance in the domestic airline industry, could soon be standing, once again, head and shoulders above the competition.

Better service? Happier and more productive workers?

Not this time. The reason for Southwest's rapidly increasing advantage over other big airlines is much simpler: It loaded up years ago on hedges against higher fuel prices. And with oil trading near $90 a barrel, most of the rest of the airline industry is facing a huge run-up in costs, and Southwest is not.

Southwest, a big flier in and out of South Florida, owns long-term contracts to buy most of its fuel through 2009 for what it would cost if oil were $51 a barrel. The value of those hedges soared as oil raced above $90 a barrel, and they are now worth more than $2 billion. Those gains would mostly be realized over the next two years.

Other major airlines passed on buying all but the shortest-term insurance against high fuel prices, allowing Southwest executives a bit of schadenfreude.

"It's true," said Scott Topping, the treasurer of Southwest and the keeper of the hedges. "We're not sure what to root for," in terms of oil prices.

Southwest is also hurt by higher fuel prices, but far less than competitors, giving the carrier a distinct advantage in an industry where beating the other guy often seems more important than actually doing well. Some other airlines, meanwhile, could start reporting losses as early as the current quarter, unless they are able to rapidly raise fares, said Roger E. King, an analyst at CreditSights, an independent research company. "Airlines were not made for $90 oil," King said in a report last week.

Indeed, at American Airlines, annual fuel costs rise $80 million for every dollar increase in a barrel of oil, said Thomas W. Horton, the chief financial officer. The difference between January's low and today's price would translate into an increase of about $3 billion a year in fuel spending. So Jamie Baker, an analyst at JPMorgan, earlier this month cut his estimate of 2008 results at AMR, American's parent, from a profit of roughly $500 million to a small loss and noted that American and others need to raise fares.

It was just 10 months ago, in January, that other airlines were enjoying the prospect of Southwest's misery. As oil dipped down to about $52 a barrel that month - Southwest's hedges cap most of its fuel needs at about $51 a barrel, so they were of little use at that point - the carrier was looking like an airline with more than its share of problems.

Traditional hub-and-spoke carriers like Delta Air Lines and Northwest Airlines had deeply cut their costs by running through bankruptcy and could now profitably compete with Southwest's fares.

Moreover, because they could draw more business travelers with first- and business-class seating and other perks, hub-and-spoke carriers could bring in more revenue per seat than Southwest.

Southwest also has the highest labor rates in the industry because it was the only big airline that had not demanded deep wage concessions from workers.

Gary C. Kelly, chief executive of Southwest, was the architect of the fuel hedging program when he was chief financial officer. The big hedges were put on starting in 2000.

The hedges have helped keep Southwest profitable, producing gains on the hedging contracts of $455 million in 2004, $892 million in 2005 and $675 million in 2006, as well as $439 million for the first nine months of 2007, as oil prices have nearly doubled this year.

These gains mostly offset rising fuel prices while other airlines were largely unprotected against the increases.

Kelly does not play down the need for Southwest to change its business, including finding ways to charge more per ticket and to reduce operating costs.

The airline has already changed its boarding policy to favor business travelers and to end the practice of passengers lining up, as if for a cattle call, an hour or more before boarding. It is looking into arrangements by which Southwest would be paid for feeding travelers to international airlines' overseas flights. And it is exploring selling tickets through channels other than its own reservation system and Web site, to better attract business travelers.

Of these and other changes designed to increase revenue at Southwest, Kelly said, "It's going to take us the entire decade." The hedges, he said, "bought us time to retool our company."